Wham, Bham, thank you Ma’am! – Financial Market chaos in 2018

On the 5th of February 2018, the Dow Jones witnessed its largest one-day point decline in its 120-year history. In total, the 30 largest US listed companies from across the New York Stock Exchange (NYSE) and the National Association of Securities Dealers Automated Quotations (NASDAQ) dropped 4.6%, a percentage decline not seen since the eurozone crisis in August 2011. Nor was the Dow alone.

As investors across the world saw the roaring US stock market come to a violent halt, stock markets in Asia and Europe started to collapse as well.

Why? What went so badly wrong that the world suddenly lost its cool and within a week almost all global indices had fallen by 6%-12%?

Most of the news for 2018 actually looked pretty great.

The IMF had upgraded global growth forecasts for 2017, 2018 and 2019, while claiming that the world was about to witness the “‘broadest’ upsurge in global growth since 2010”. Global Mergers & Acquisition activity was at its highest since the dot.com boom over 17 years ago, the eurozone grew at its fastest rate in a decade and manufacturing growth has exploded across the US, Europe and the UK.

Given these factors, many retail investors and ordinary people reasonably asked the question: “Why did everything collapse and what should I do with my money now”? In an attempt to answer the first part, we have to begin with separating the event itself (the stock market collapse), and the reasons behind the crash (the fundamentals).

There are many different and authoritative views on this issue, including a very easy and concise piece by Bloomberg available here. My take is below:

With interest rates at record lows, the stock-market continuing to grow at breakneck speed and the global economy expanding, people have thrown caution to the wind and invested in the stock markets. In fact, January 2018 witnessed record levels of investment in the stock-market, as confidence took over and people from all walks of life began to invest. This is where the problem started.

Everyone in the stock market had been waiting for a fall. But knowing when it would come had been a significant challenge. If investors left too early, they would be potentially giving up the chance to make more money. If they left too late, they may lose everything. On January 29th and 30th, the first investors lost their calm and pocketed their gains and as January came to a close, the US stock market saw two days of consecutive decline and its largest fall since May 2017 (a small blip in comparison to what would happen later).

But why were the professional investors sceptical of the market? Here again we must return to expectations.

The aim of a professional investor is to generate returns that exceed what could be earned by investing in a risk-free asset. In simple terms “risk free” usually means bank deposits and the bonds of the worlds most financial secure markets (US, UK, Switzerland, German). The reason they are “risk free” is because most bank deposits are covered by insurance and because these governments are considered financially prudent enough to guarantee that any money owed to investors will always be repaid. Naturally this sounds like a great deal for investors. Put your money into a bond and earn a guaranteed amount of interest. What is not to like? Well the problem is that after the financial crisis too many investors thought that this was a good idea and so as the demand for bonds increased, their price increased. To cut a long story short, when the price of a bond increases the interest (read return) gets smaller. This is where the problem started.

Risk free bonds are the benchmark for professional investors. The expectation is to beat the risk free rate and the more risk the investor is asked to take, the bigger the return they expect (over the risk free rate). But if the risk free rate is extremely low, then risky investments can look increasingly attractive if investors cannot reach their target return through traditional investments. Pension funds are an excellent example of this. Prior to 2008 a pension fund would expect to pay 3% of all its funds under management out to its retirees every year. Therefore, as long as the pension fund could earn over 3% the fund would meet its obligations. Conveniently several types of government bond from the UK, USA and across leading economies were paying around 5% prior to 2008, allowing pension funds to make a 2% profit and meet all of their commitments, with minimal risk. But the financial crisis and ultra-low interest rates changed everything.

 As interest rates dropped to nearly 0% (in some cases negative), investors like pension funds, were forced to find other ways to generate their returns and so they piled into property, real assets (gold, oil, etc) and stocks. Accordingly, the stock market exploded. It didn’t matter that a company was now generating 3% return a year (compared to 5%) because its share price had risen. The alternative was a 1% government bond.

So back to 2018, the key question for investors was this: when would interest rates rise sufficiently that large money managers would sell their stocks? After all, if the interest rate rises then the return from the stock must price in tandem at every step. But that cannot happen forever.

So the magic number was 3%. Specifically, investors began to believe that rising wage inflation in the US at the end of January would increase the interest rate on US ten-year debt to 3%. If inflation was high, the US Federal Reserve would increase rates and money managers would sell their stocks. In Germany the same thing happened when the largest German workers union negotiated an inflation busting pay rise in February, leading to significant stock market declines in the US stock market (the 2nd worst performer after the Dow Jones).

What next?

The financial markets have broadly calmed following their collapse at the start of the month, but the truce remains uneasy. It is clear that investors remain extremely uncertain whether the sharp decline in share prices remains the only price “correction” that we shall see for the year, or if it is merely an early warnings tremor before a larger financial earthquake later in the year. On this question, expert opinion is fiercely divided.

However, for people interested in following the stock market closely its worth looking at whether any of the large companies, famously called “Unicorns” choose to finally go public this year. Traditionally private companies go public when they believe that valuations are at record highs, not when they believe that there is space to grow. So if you see AirBnB, Uber or even Spotify go public, then maybe consider putting some more cash in the bank and out of the stock market.

Important disclaimer here: This piece merely reflects the views of the author and should not be considered as financial guidance or advice.

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